Working in partnership with Free The Children, KPMG is helping our people make a meaningful contribution to development by putting our skills to work - internationally, in our communities, and with our families.

CRA Says Debt Forgiveness Rules Can Apply to Family Loans - by Pam Prior and John Fabbro

Canadian Tax Adviser

January 15, 2013

Pam PriorMontreal, International Corporate Tax

John Fabbro Toronto, Enterprise Tax

In a recent technical interpretation, the CRA confirmed that the debt forgiveness rules in section 80 apply on the inter vivos settlement of non-arm's length obligations resulting from the gifting of notes held by a surviving spouse's spousal trust to her children. The CRA said that, in the example given, because the debt was settled by the surviving spouse (and not as a result of the deceased taxpayer's will), the forgiveness of debt rules could reduce the adjusted cost base of the children's shares that were previously purchased using the notes.

Hypothetical scenario

Father sold shares of Canco to his children (the Children), and took back non-interest bearing notes (Notes Receivable) as consideration. The principal amount of the Notes Receivable was equal to the fair market value of the shares. Father recognized a taxable capital gain on the disposition of the shares to the Children.

On Father's death, Father's will required the Notes Receivable to be transferred to a spousal trust for the benefit of his wife (Spouse). Spouse was entitled to income and capital distributions from the trust during her lifetime. Spouse obtained the Notes Receivable from the trust as a return of capital.

Spouse gifted the Notes Receivable to the Children, with the intention that they be settled (at fair market value, which is equal to their principal amount), or offset against the Notes Payable held by the Children.

Issue At issue is whether the debt forgiveness rules in section 80 would apply to these inter vivos settlements of non-arm's length obligations (i.e., the Notes Payable).

Legislative backgroundGenerally, the debt forgiveness rules can apply when an obligation is settled or extinguished, except for debts settled or extinguished by bequest or inheritance (as stated in paragraph 80(2)(a)).

Where a personal trust or a prescribed trust distributes its property to a beneficiary and, as a result, all or any part of the beneficiary's capital interest in the trust is disposed of, the trust is generally deemed to have disposed of the property for proceeds of the disposition equal to its cost amount to the trust immediately before that time under subparagraph 107(2)(a).

When a property is gifted inter vivos, the transferor is deemed to have received proceeds equal to the fair market value of the property (under paragraph 69(1)(b)), and the recipient is deemed to have acquired the property at its fair market value (under paragraph 69(1)(c)).

Interpretation Bulletin IT-293R, "Debtor's Gain on Settlement of Debt", states in paragraph 6 that a debt or obligation is settled or extinguished when all liability for payment is terminated. This bulletin notes that a settlement can be accomplished by methods including payment, cancellation, set-off, substitution of debtors and release.

The CRA noted that, had Father's will extinguished the Notes Receivable, the debt forgiveness rules in section 80 would not have applied due to the exception under paragraph 80(2)(a). However, the will instead transferred the Notes Receivable to the spousal trust at fair market value, making that their cost amount to Spouse under subsection 107(2).

The transfer of the Notes Receivable to Spouse would cause the trust to be deemed to have received proceeds equal to its cost of the Notes Receivable (or fair market value in this scenario) under paragraph 107(2)(a).

The CRA commented that, once Spouse gifts the Notes Receivable to the children, the Notes Payable would be settled and the liability to repay the Notes Payable would be extinguished. Therefore, the CRA stated that the debt forgiveness rules would apply to reduce the adjusted cost base of the children's shares by any forgiven amount under subsection 80(11).

KPMG observationsWhile the facts in the TI are vague, it appears that, in the hypothetical scenario provided, there might be no forgiven amount when the Notes Payable are settled. This assumes, for example, that the face value of the Notes Receivable and Notes Payable continued to be their fair market value at all relevant times.

For more information, contact your KPMG adviser.

Information is current to January 15, 2013. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's National Tax Centre at 416.777.8500

KPMG International Cooperative ("KPMG International") is a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm.